Derivatives
| Author | Patrick Casabona |
| Pages | 195-198 |
Page 195
Derivative instruments are used as financial management tools to enhance investment returns and to manage such risks relative to interest rates, exchange rates, and financial instrument and commodity prices. Several local and international banks, businesses, municipalities, and others
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have experienced significant losses with the use of derivatives. However, their use has increased as efforts to control risk in complex situations are perceived to be wise strategic decisions.
In 1998, the Financial Accounting Standards Board (FASB) issued Statement on Financial Accounting Standards No. 133 (SFAS 133), Accounting for Derivative Instruments and Hedging Activities, which is effective for companies with fiscal years beginning after June 15, 2000. SFAS 133 establishes new accounting and reporting rules for derivative instruments, including derivatives embedded in other contracts, and for hedging activities. Derivatives must now be reported at their fair values in financial statements. Gains and losses from derivative transactions must be reported currently in income, except from those transactions that qualify as effective hedges.
According to Statement on Financial Accounting Standards (SFAS) 133, a derivative instrument is defined as a financial instrument or other contract that represents rights or obligations of assets or liabilities with all three of the following characteristics:
It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both. Those terms determine the settlement amount of the derivative. An underlying is a variable (i.e., stock price) or index (i.e., bond index) whose market movements cause the fair value market or cash flows of a derivative to change. The notional amount is the fixed amount or quantity that determines the size of the change caused by the change in the underlying; possibly a number of currency units, shares, bushels, pounds, or other units specified in the contract. A payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner.
It requires no initial net investment or an initial net investment that is smaller than would be required for other types of similar instruments.
Its terms require or permit net settlement (SFAS 133, paragraph 6).
The derivatives market serves the needs of several groups of users, including those parties who wish to hedge, those who wish to speculate, and arbitrageurs.
A hedger enters the market to reduce risk. Hedging usually involves taking...
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